Climate change and real estate: how to predict property damage

What has enabled humanity to successfully cope with the climate, at every latitude of the globe? Stability. Naturally, everyone would love to live in San Diego, with its beautiful nature and balmy climate, but many have also learned how to live in Alaska or the Sahara. What is today’s biggest problem? It’s the very opposite of stability: climate change. This change can be beneficial for some and damaging for others; in the latter case we need to identify the worst potential damage. From the standpoint of corporate real estate, adapting to a noticeably different environment is not just about controlling the temperature, but also encompasses the impact of variations in the demands of customers, who in turn are guided by climate change. And this beyond the possible damage linked to extreme weather events which, in our new normal, can occur much more often than ever before.

But how can we come up with a method that allows us to quantify potential damage? Since the ‘80s the financial sector has developed a way to determine risk, known as Value at Risk (VaR). This metric makes it possible to estimate the probability distribution of the value of any given asset. More recently, in 2019 the United Nations Environmental Program Finance Initiative advanced an innovative method for computing the risk of loss of value for corporate or financial institutions caused by climate change, considering both the transition risks (the cost of implementing carbon-reduction policies for businesses), and physical risks (damage that the upsurge in the frequency and intensity of severe weather events can cause to economic agents). Our proposal instead is to present a method for calculating the Climate Value at Risk (CVaR), to quantify the risk factors linked to climate change as they impact real estate assets. We call our metric Real Estate Climate Value at Risk (RECVaR).

To clarify our reasoning, let’s use an example. Say we have a building project for an 80-room, 4,250 m2 luxury hotel. The room rate will be €300 a day, and the occupancy rate is projected at 65% for the first year and 70% for the second, rising to 80% once the structure is fully functional (from year three on). As far as the costs of climate change, we estimate the transition risk by assuming that the hotel will have to pay a price on carbon emissions linked to the market price of emission rights. This cost hovered below €5 per metric ton up until 2017, but has since skyrocketed up to €90 in early 2022, sliding slightly to €80 after the outbreak of the war in Ukraine.

For this building project, we estimate the emissions from the kWh of power needed to run the hotel and the grams of CO2 generated from related energy use. In the most likely scenario, we estimate an energy use of 301 kWh per m2 per year; CO2 emissions from energy use, according to data from the European Environmental Energy for Italy, equal an estimated 248 grams per kWh. Based on this hypothesis, the emissions from our hotel total 74.6 Kg of CO2 per m2 per year. Next we simulate the entire business plan of the project, factoring in various elements of risk linked to economic variables, energy efficiency enhancement, and the impact on the surrounding environment in relation to the risks we mentioned above, i.e. physical risks and transition risks.

Our results show that climate change can have an appreciable impact on asset value, considering the fact that: VAN plummets by 60% and TIR sinks from 8.63% to 7.14%. The worst case scenario (with a 1% probability of occurrence), which if there were no climate change risk, would be the equivalent of €2,415,928, becomes €290,914. The additional loss of €2,125,014 - corresponding to 57% of the initial value - is due to the impact of climate change.

This is simply an example, but it does illustrate the power of our method, which can be utilized by asset owners and financers alike who need to consider climate risk among the other variables to estimate the maximum portfolio loss. Economic operators must make long-term investment decisions by rationally balancing the prospects of economic value with risk factors, but in doing so from a long-term perspective, we must not neglect climate change, the primary non-diversifiable risk with the potential to influence any type of activity.

Clearly climate risk overlaps and interacts with normal operational and financial risks in business. So it is crucial to come up with a method that can incorporate all these sources of risk. The possibility of attributing the reduction of economic value and the internal rate of return to specific climate-related factors further contributes to making our method simple and easy to use and interpret. And this is true not only for entrepreneurs but also for providers of credit and equity, and financial intermediaries in general who have been using Value at Risk models for over 20 year to quantify market risk, credit risk, operational risk, and so on.

What we are proposing represents a generalization of Value at Risk, so it should easily be assimilated in the models that are already being used. Sadly, it’s easy to see that in the coming years this kind of calculation will become the norm, but it is already necessary today for anyone who has to manage risky situations.